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I. Working Capital Management is the administration and control of the company's working capital.
The primary objective is to achieve a balance between return (profitability) and risk.
2. Aggressive (Restricted) Policy - operations are conducted on a minimum amount of working capital
uses short-term liabilities to finance, not only temporary, but also part or all of the permanent current
asset requirement.
Advantage
• increase return on equity (profitability) by taking advantage of the differential spread between
long-term and short-term debt.
Disadvantage
• exposure to risk arising from low working capital position.
• puts too much pressure on the firm's short-term borrowing capacity so that it may have
difficulty in satisfying unexpected needs for funds.
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes
3. Matching Policy (also called self-liquidating policy or hedging policy) - matching the maturity of a
financing source with specific financing needs.
• short-term assets are financed with short-term liabilities.
• long-term assets are funded by long-term financing sources.
4. Balanced Policy - balances the trade off between risk and profitability in a manner consistent with
its attitude toward bearing risk.
VI. Forecasting
Percentage of sales forecasting method is a simple but practical procedure for forecasting financial
statement variables. The procedures are based o to assumptions: (a) that all variables are tied directly
with sales; and, (b) that the current levels of most balance sheet items are optimal for the current sales
level.
Steps;
1. Identify assets and liabilities that will vary spontaneously with sales.
2. Estimate the amount of net income that will be retained.
3. Compute the amount of External Financing Needed (EFN) by subtracting increase in
spontaneous liabilities and income retained from increase in total financing required (increase in assets
due to increase in sales.)
1. Cash Management
Objective: Optimum amount of cash, (not excessive nor deficient) at the right time.
Excess cash should be invested for a return while retaining sufficient liquidity.
Thrust of Cash Management: accelerate cash receipts and delay cash payments.
The least amount of cash a firm should hold is the greater of compensating balance or precautionary
balance plus transaction balance.
Operating Cycle. The amount of time elapses from the point when the firm inputs materials and labor into
the production process to the point when cash is collected from the sale of the finished goods. This
consists of two components – average age of inventory and the average collection period receivables.
Cash Conversation Cycle. Total number of days in operating cycle less average payment period for
materials.
Useful Formulas
Inventory Receivables Payable
Cash Conversion Cycle = Conversion Cycle + Collection Period – Deferral Period
Or or or
Average Age + Average Age – Average Age
Of Inventories of Receivables of Payables
Pay accounts payable as late as possible without damaging the firm’s credit rating, but take
advantage of any favorable ash discounts.
Components of Float;
Mail float – The delay between the time when a payer mails a payment and the time when
the payee receives it.
Processing Float. The delay between the receipt of a check and its deposit I the firm’s
account.
Clearing Float. The delay between the deposit of a check by the payee and the actual
availability of the funds.
Speeding up Collections
Concentration banking. A scheme where a firm with numerous sales outlets designated
certain offices as collection center for a given geographic areas. These collection centers
deposit the receipts in local banks; in turn, these local banks transfer the funds by the wire to
a concentration or disturbing bank.
Lock boxes. Instead of mailing payment to a collection center, the payer sends it to a post
office box that is emptied by the firm’s bank several times daily. The bank deposits the
checks in the firm’s account and sends to the collecting firm a deposit slip or computer
printout indicating the payments received.
Direct sends. Firms that have been received large checks drawn on distant banks or a large
number of checks drawn on banks in a given city may arrange to present those checks
directly for payment to the bank on which they are drawn.
Objective:Determine the amount to be invested in marketable securities and when to convert the same to
cash
Thrust of Marketable Securities Management: Balance the conversion costs and opportunity costs in
converting marketable securities.
Economic Conversation Quantity (Optimal Transaction Size). Using the conversion and opportunity
costs, the model calculates the economic conversion quantity, the amount (cost-optimizing- quantity) in
which the firm should convert marketable securities to cash or cash to marketable securities.
_____________________________________
ECQ=/2x Conversion Cost x Annual Demand for cash
1/ Opportunity Cost (in decimal)
Conversion cost= the cost of converting marketable securities to cash. It includes the fixed costs of
placing an order for cash or marketable securities, paperwork costs, brokerage fees, and cost of any
follw-up action.
Opportunity Cost of Cash= (Cost per conversion x number of conversion)+ (opportunity cost x Average
cash balance)
Objective: Formulation and administration of plans and policies related to sales on account and ensuring
the maintenance of receivables at a predetermined level and their collectibility as planned.
Thrust of Accounts Receivable Management: To have both the optimal amount of receivables
outstanding and the optimal amount of bad debts.
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes
2. Credit Standards - the criteria that determine which customers will be granted credit and how
much. The credit standard should not be too stringent or too tight which may eliminate the risk of
non-payment, but also eliminate potential sales to rejected customers; neither should the
standards be too loose or liberal, which may lead to higher sales, but also higher bad debt losses
and collection costs.
Factors to consider in establishing Credit Standards
Character - a customer's willingness to pay
Capacity - a customer's ability to generate cash flows
Capital - a customer's financial sources such as collateral
Conditions - current economic or business conditions.
Cost of Marginal Bad Debts= Bad debts under proposed plan- Bad debts under present plan
3. Inventory Management - formulation and administration of plans and policies to efficiently and
satisfactorily meet production and merchandising requirements and minimize costs relative to inventories.
Objective: Maintain inventory at a level that best balances the estimates of actual savings, the cost of
carrying additional inventory, and the efficiency of inventory control.
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes
2. Inventory Control - regulation of inventory within predetermined level; adequate stocks should be
available to meet business requirements, but the investment in inventory should be at the
minimum.
a. Fixed Order Quantity System - an order for a fixed quantity is placed when the inventory
level reaches the reorder point.
b. Fixed Reorder Cycle System (periodic review or replacement system) - orders are made
after a review of inventory levels has been done at regular intervals.
c. Optional Replacement System
d. ABC Classification System - inventories are classified for selective control:
A items - high value items requiring highest possible control
B items - medium cost items requiring normal control
C items - low cost items requiring the simplest possible control
Inventory Models
A basic Inventory Model exists to assist in two inventory questions:
1. How many units should be ordered?
2. When should the units be ordered?
Economic Order Quantity - the quantity to be ordered, which minimizes the sum of the ordering and
carrying costs. The total inventory cost function includes:
1.Carrying Costs (which increase with order size)
a. Storage costs c. Spoilage
b. Interest costs d. Insurance
Note: When applied to. manufacturing operations, the EOQ formula may be used to compute the
Economic Lot Size (ELS)
Where: a = set-up cost
2aD D = annual production requirement
ELS = k k = annual costs of carrying one unit in inventory for
one unit in inventory for one year
When the EOQ figure is available, the average inventory is computed as follows:
Average inventory = EOQ
2
Reorder Point:
When to reorder is a stock-out problem, i.e., the objective is to order at a point in time so as not
to run out of stock before receiving the inventory ordered but not so early that an excessive
quantity of safety stock is maintained. When the order point is computed, there may be a stock-
out situation if:
1. demand is greater than expected during the lead time; or
2. the order time exceeds the lead time.
Lead Time - period between the time the order is placed and received
Normal Time Usage = Normal lead time x Average usage
Safety Stock = (Maximum lead time - Normal lead time) x Average usage
REORDER POINT IF THERE IS NO SAFETY STOCK REQUIRED = Normal lead time usage
Safety stock + Normal lead time usage
REORDER POINT IF THERE IS SAFETY STOCK REQUIRED or
Maximum lead time x Average usage
I. Spontaneous Sources
A. Trade Credit / Accounts Payable — considered as a spontaneous financing because it is
automatically obtained when a firm purchases goods or services on credit from a supplier.
> It is a continuous source of financing.
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes
> It is more readily available than other negotiated sources of short-term credit.
Cost of Trade Credit
Trade credit usually bears no interest, but it is not costless. Its cost is implicit in the terms
of credit agreed upon (the discount policy and the credit period).
1. No Trade Discount
Purchases on credit without trade discount are usually priced higher than cash
purchases. The difference between the selling prices is the implicit cost of credit.
2. With Trade Discount
If a supplier allows a trade discount for prompt payment, an implicit cost is incurred if
the discount is not availed of.
Example: Credit term is 2/10, "/30 - The purchaser is given 2% discount if the account
is paid within 10 days.
If the discount is not taken and the purchaser pays on the 30 th day, this means that he had 20 days
more of financing (30 days – 10 days). The cost of this additional financing is the discount foregone,
which is, in effect, a penalty or interest cost. The annual rate is computed as follows:
Assuming 360 days in a year is used in the calculation, the annual rate in this example is:
2% 360 days
Annual Rate = x
100% - 2% 30 days – 10 days
2% 360 days
= x = 36. 73%
90% 20 days
B. Accruals (Accrued Expenses) - another form of spontaneous financing, which represent liabilities
for services that have been provided to the company but have not yet been paid for. Typical
examples are accrued wages and taxes.
COST OF ACCRUALS - None, whether implicit or explicit cost.
C. Deferred Income - customers' advance payments or deposits for goods or services that will be
delivered at some future date.
COST OF DEFERRED INCOME – None
B. Commercial Paper - short-term, unsecured promissory notes (IOUs) issued by large firms with
great financial strength and high credit rating to other companies and institutional investors,
such as trust funds, banks, and insurance companies. Commercial papers entail lower cost
than bank financing (the interest rate is usually lower that the prime rate* and the costly
financial arrangements are avoided). One disadvantage, however, is their limited access and
availability. Only the largest firms with the greatest financial strength can issue commercial
papers. The amount of funds available is limited to the excess liquidity of big corporations.
* Prime Interest Rate - the rate charged by commercial banks to their best business clients. - It
is usually the lowest rate charged by banks.
Cost of Commercial Paper
Effective Annual = Interest Cost per period x Number of days in a year
Interest Rate Usable Loan Amount Number of days funds are borrowed
Example: Giant Corporation plans to issue P500M in commercial paper for 180 days at a
stated, discounted interest rate of 10%. Dealers of the commercial paper usually charge
P200, 000 in placement fees and flotation costs. (Use 360 days in a year)
I. Capital Structure - the mix of the long-term sources of funds used by the firm. (This is different from
FINANCIAL STRUCTURE which is the mix of all the firm's assets.)
Objective: to maximize the market value of the firm through an appropriate mix of long-term sources of
funds.
Cost of Capital - the cost of using funds; it is also called hurdle rate, required rate of return, cut-off rate. It
is the weighted average rate of return the company must pay to its long-term creditors and shareholders
for the use of their funds.
Computation of Cost of Capital
Source Capital Cost of Capital
Creditors Long-term debt After-tax rate of interest i (1 - TxR)
Stockholders:
Preferred dividends per share
Preferred Preferred stock
Current market price or Net issuance price
Earnings per share
Common Common stock
Market price per share
Leverage
1. Operating Leverage - (a measure of operating risk) refers to the fixed operating costs found in
the firm's income statement
THE HIGHER THE FIRM'S OPERATING LEVERAGE, THE HIGHER ITS BUSINESS RISK,
AND THE LOWER ITS OPTIMAL DEBT RATIO
Degree of Operating Leverage (DOL) = CM
EBIT
2. Financial Leverage - (a measure of financial risk) refers to financing a portion of the firm's
assets, bearing financing charges in hopes of increasing the return to the common
stockholders.
THE HIGHER THE FINANCIAL LEVERAGE, THE HIGHER THE FINANCIAL RISK, AND
THE HIGHER THE COST OF CAPITAL
A. Debt Financing
Advantages:
1. Basic control of the firm is not shared with the creditor.
2. Cost of debt is limited. Creditors usually do not participate in the superior earnings of
the firm.
3. Interest paid is tax deductible, thereby reducing cost of capital.
4. Substantial flexibility in the financial structure is enhanced by debt through the
inclusion of call provisions in the bond indenture.
5. The financial obligations are clearly specified and of a fixed nature.
6. In time of inflation, debt may be paid back with "cheaper pesos".
Disadvantages:
1. Since debt requires a fixed charge, there is a risk of not meeting this obligation if the
earnings of the firm fluctuate.
2. Debt adds risk to t. firm.
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes
C. Hybrid Financing - sources of funds that possess a combination of features; these include preferred
stock, leasing, and option securities such as warrants and convertibles.
Preferred Stock - a hybrid security because some of its characteristics are similar to those of both
common stocks and bonds. Legally, like common stock, it represents a part of ownership or
equity in a firm. However, as in bonds, it has only a limited claim on a firm's earnings and
assets.
Features of Preferred Stock Issues
a. Priority to assets and earnings - the claims of preferred stockholders must first be
satisfied before the cor,,mon stockholders receive anything.
b. Preferred stocks al' .,.ys have par value, which is important in determining the
amount due to Preferred Stockholders in case of liquidation and in computing the
preferred dividends.
c. Most preferred stocks provide for cumulative dividends.
d. Some preferred stock issues are convertible to common stocks.
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes
Lease Financing
Lease - a rental agreement that typically requires a series of fixed payments that extend over
several periods.
Leasing vs. Borrowing - leasing represents an alternative to borrowing. The lease payments are
very similar to loan amortization, with part of payment applied to principal, and part to interest. Like
loan agreements, lease contracts usually contain restrictive covenants like the requirement to
maintain minimum debt-equity ratios or minimum level of liquid assets.
• Basic difference of leasing from debt: ownership of the asset Leasing Benefits
1. Increased Flexibility - in some cases, lease can be cancelled or replaced with a new one,
depending on the need of the firm.
2. Certain maintenance at a known cost
3. Lower administrative costs - a company may just let some other party to take care of its assets
instead of creating a new department to take care of the acquisition, maintenance, and
eventual sale of the asset.
4. The tax shield generated by lease payments usually exceeds that from depreciation if the
asset were purchased.
Types of Leases
1. Operating Lease - usually short-term and often cancelable; obligation is not shown on the
balance sheet; maintenance and upkeep of asset is provided by the lessor;
lease payment is treated as rent expense.
2. Financial or Capital Lease - non-cancelable, longer-term lease that fully amortizes the
lessor's cost of the asset; service and maintenance are usually provided by the
lessee.
3. Sale-Leaseback Arrangement - assets that are already owned by a firm are
purchased by a lessor and leased back to the firm.
4. Direct Leases - identical to the sale-leaseback arrangement, except that the
lessee does not necessarily own the leased asset; the lessor already owns or
acquires the asset, which is then provided to the lessee.
5. Leveraged Leases - a special lease arrangement under which the lessor borrows
a substantial portion of the acquisition cost of the leased asset from a third party.
> CONVERTIBLE SECURITIES - preferred stock or debt issue that can be exchanged for a
specified number of shares of common stock at the will of the owner. These are
considered hybrid securities because they provide the stable income associated
with preferred stock and bonds in addition to the possibility of capital gains
associated with common stocks.
Advantages and Disadvantages of Issuing Convertible Securities:
Disadvantages
1. Sale of convertibles may be thought of as
Working Capital Management
Assistant Professor Ronaldo C. Reyes
OPTION - created by outsiders rather than the firm itself, it is a contract that gives its holders the right to
buy (or sell) stocks at some predetermined price within a specified period of time.
WARRANT - an option granted by the corporation to purchase a specified number of shares of common
stock at a stated price exercisable until some time in the future called the expiration date. It is a
company-issued call option. Often, it is attached to debt instruments as an incentive for
investors to buy the combined issue at a lower interest rate.
***************The End***************